CFA Institute CFA Institute Certifications CFA-LEVEL-1 Questions & Answers

• Question 1321:

  Ace Consulting, a corporate finance consulting firm, is examining the operating performance of Microscam Incorporated. In their analysis, Ace Consulting has identified the following information: Year 1 interest paid $28,000 Year 2 interest paid $35,000 Year 1 sales $1,675,000 Year 2 sales $1,895,000 Year 1 EBIT $750,000 Year 2 EBIT $987,500 Cost of debt 7.70% Given this information, what is the Degree of Operating Leverage for this firm during the time period in question?

  A. 1.531

  B. 2.431

  C. The Degree of Operating Leverage cannot be calculated due to the fact that an appropriate discount rate has not been provided.

  D. 2.412

  E. 2.618

  F. 0.415

  Correct Answer: D

  To calculate the degree of operating leverage, use the following equation: {% change in EBIT/% change in sales}. In this example, neither the percentage change in sales, neither the percentage change in EBIT are provided, and must be calculated manually. To calculate the percentage change in sales, use the following equation: {[sales in year 2 - sales in year 1]/sales in year 1}. Incorporating the given information into this calculation yields a % change in sales of 13.13%. To calculate the percentage change in EBIT, use the same equation as follows: {[EBIT in year 2 - EBIT in year 1]/EBIT in year 1}. Incorporating the given information into this calculation yields a percentage change in the EBIT of 31.67%. Finally, to calculate the Degree of Operating Leverage, divide the percentage change in EBIT by the percentage change in sales, which derives a DOL of 2.412. The "interest paid" information is irrelevant in the calculation of the DOL, rather is incorporated into a determination of the Degree of Financial Leverage. This information has been provided to trick you. Additionally, the Degree of Operating Leverage can be calculated regardless of whether an appropriate discount rate has been provided or not.

• Question 1322:

  Cochran Corporation has a weighted average cost of capital of 11 percent for projects of average risk. Projects of below-average risk have a cost of capital of 9 percent, while projects of above-average risk have a cost of capital equal to 13 percent. Projects A and B are mutually exclusive, whereas all other projects are independent. None of the projects will be repeated. The following table summarizes the cash flows, internal rate of return (IRR), and risk of each of the projects. Year (t)Project A Project B Project C Project D Project E O-200,000-100,000-100,000-100,000-100,000 166,00030,00030,00030,00040,000 266,00030,00030,00030,00025,000 366,00040,00030,00040,00030,000 466,00040,00040,00050,00035,000 IRR12.1114.03810.84816.63611.630 ProjectBelowBelowAverageAboveAbove RiskAverageAverageAverageAverage Which projects will the firm select for investment?

  A. Projects: A, D

  B. Projects: B, C, D, and E

  C. Projects: B, D

  D. Projects: B, C, and D

  E. Projects: A, B, and D

  Correct Answer: A

  Look at the NPV, IRR, and hurdle rate for each project: ProjectABCDE Hurdle9.00%9.00%11.00%13.00%13.00% NPV$13,822$11,998 IRR12.11%14.04%10.85%16.64%11.63% Projects A and B are mutually exclusive, so we pick project A because it has the largest NPV. Projects C, D, and E are independent so we pick the ones whose IRR exceeds the cost of capital, in this case, just D. Therefore, the projects undertaken are A and D.

• Question 1323:

  In theory, the decision-maker should view market risk as being of primary importance. However, within-firm, or corporate, risk is relevant to a firm's

  A. All of the answers are correct.

  B. None of the answers are correct.

  C. Creditors, because it affects the firm's credit worthiness.

  D. Management, because it affects job stability.

  E. Well-diversified stockholders, because it may affect debt capacity and operating income.

  Correct Answer: A

  These are all relevant to a firm's corporate risk, which is measured by the project's impact on uncertainty about the firm's future earnings.

• Question 1324:

  Arizona Rock, an all-equity firm, currently has a beta of 1.25, and k(RF) = 7 percent and k(M) = 14 percent. Suppose the firm sells 10 percent of its assets (beta = 1.25) and purchases the same proportion of new assets with a beta of 1.1. What will be the firm's new overall required rate of return, and what rate of return must the new assets produce in order to leave the stock price unchanged?

  A. 15.750%; 15.645%

  B. 14.750%; 15.750%

  C. 15.645%; 14.700%

  D. 15.750%; 14.700%

  E. 15.645%; 15.645%

  Correct Answer: C

  b(old, firm) = 1.25.

  k(old, firm) = 0.07 + (14 - 7)1.25 = 15.75%.

  b(new, firm) = 0.9(1.25) + 0.1(1.1) = 1.235.

  k(new, firm) = 0.07 + 1.235(0.07) = 15.645%.

  k(new, assets) = 0.07 + 1.1(0.07) = 14.7%.

• Question 1325:

  In order for the NPV and MIRR methods to consistently produce similar rankings, the projects being examined must possess which of the following characteristics? Choose the best answer.

  A. Projects must be independent and equal in size

  B. Projects must equal in scale and be mutually exclusive

  C. Projects must be profitable and have normal cash flows

  D. Projects must equal in scale and have the same life

  E. Projects must equal in scale and have identical cash flows

  F. Projects must have equal lifespans and normal cash flows

  Correct Answer: D

  When examining mutually-exclusive projects with normal cash flows, the MIRR and NPV methods will ALWAYS produce similar results as long as the projects being examined are equal in size and have the same life.

• Question 1326:

  Which of the following projects would likely produce multiple Internal Rates of Return? Assume a 14% discount rate. Project A Initial investment outlay: ($500,000) t1: $900,000 t2: ($100,000) t3: ($100,000) t4: ($10,000) Project B Initial investment outlay: ($500,000) t1: $0.00 t2: $650,000 Project C Initial investment outlay: ($50,000) t1: $0.00 t2: $0.00 t3: $65,000 t4: $0.00 t5: $0.00 t6: $65,000 Project D Initial investment outlay: ($1,000,000) t1: $675,000 t2: $675,000 t3: ($1,500) t4: $1,500 Project E Initial investment outlay: ($1,000,000) t1: $0.00 t2: $0.00 t3: $0.00 t4: $0.00 t5: $2,000,000

  A. Project A, D, and E

  B. Project A and D

  C. Project C

  D. All of these projects will likely result in multiple Internal Rates of Return.

  E. Project B

  F. Project A

  Correct Answer: B

  First of all, the cost of capital is irrelevant in Internal Rate of Return calculations. What is being examined in this example is the determination of "normal" versus "non-normal" projects. Non-normal projects are classified as projects that possess non-normal cash flows. In evaluating projects with "non-normal cash flows" the Internal Rate of Return method will often produce multiple IRRs which leads to an incorrect accept/reject decision. Non-normal cash flows are defined as cash flows in which the sign changes more than once. Projects A and D involve cash outflows superimposed within their cash inflows, resulting in a sign change from positive to negative and negative to positive. In examining projects such as this, it is advisable to use either the NPV or MIRR methods, which are not subject to the problem of multiple IRRs. From observation alone, we can determine that project A and D are non-normal projects, and are thus likely to result in multiple IRR calculations. While project B, C and E have periods of zero cash flows, each only has one change of sign in the overall cash flow process, and therefore all three projects should be characterized as "normal" for purposes of examination. While the cost of capital has been provided, it is not necessary for the determination of the correct answer in this case. What you should look for are projects with non-normal cash flows, and this should not involve any computational analysis. Besides, the cost of capital is not incorporated into the Internal Rate of Return calculation, rather, it is a component of the NPV and MIRR computational methods.

• Question 1327:

  Ameriscam, Inc. is considering the issuance of some perpetual preferred stock. The Company's corporate tax rate is 30%, and the yield on its outstanding senior debt is 7.55%. Additionally, Ameriscam has been told by a leading investment bank that if issued, its preferred stock would merit a price of $40 net of flotation costs and other charges. If issued, the firm plans to dedicate preferred annual dividends of $2.35 per share. What is the cost of the proposed preferred stock for this firm?

  A. The cost of preferred stock cannot be calculated from the information supplied.

  B. 2.265%

  C. 7.98%

  D. 0.0875%

  E. 5.875%

  Correct Answer: E

  The cost of preferred stock can be found by dividing the annual dividend by the issuing price, which is net of any underwriting, or "flotation," charges. The cost of preferred stock in this example is very low. Typically, the cost of preferred stock is greater than the cost of debt but less than the cost of common equity.

• Question 1328:

  Petersen Co. has a capital budget of $1,200,000. The company wants to maintain a target capital structure, which is 60 percent debt and 40 percent equity. The company forecasts that its net income this year will be $600,000. If the company follows a residual dividend policy, what will be its payout ratio?

  A. 20%

  B. 80%

  C. 60%

  D. 40%

  E. 0%

  Correct Answer: A

  The amount of new investment, which must be financed with equity, is: $1,200,000 x 40% = $480,000. Since the firm has $600,000 of net income only $120,000 will be left for dividends. This means the payout ratio is $120,000/$600,000 = 20%.

• Question 1329:

  Which of the following is not expressly incorporated into the Degree of Total Leverage (DTL) calculation?

  A. Sales

  B. Fixed costs

  C. Variable costs

  D. Interest expense

  E. None of these answers

  F. Common shares outstanding

  Correct Answer: F

  The Degree of Total Leverage (DTL) calculation measures the percentage change in EPS from a given percentage change in sales. The equation used to produce DTL is as follows: {DTL = [(Sales - Variable Costs) / (Sales - Variable Costs - Fixed Costs - Interest Expense)]. Of all the choices listed, "only the number of common shares outstanding" is not expressly incorporated into the DTL calculation.

• Question 1330:

  The following facts apply to your company:

  Target capital structure: 50% debt; 50% equity.

  EBIT:$200 million

  Assets:$500 million

  Tax rate:40%

  Cost of new and old debt:8%

  Based on the residual dividend policy, the payout ratio is 60 percent. How large (in millions of dollars) will

  the capital budget be?

  A. $43.2

  B. $50.0

  C. $108.0

  D. $86.4

  E. $64.8

  Correct Answer: D

  Debt = 0.5(Assets) = 0.5($500) = $250 million.

  Interest = 0.08($250) = $20 million.

  EBT = EBIT - I = $200 - $20 = $180.

  NI = $180 - Taxes = $180 - $180(0.4) = 0.6($180) = $108 million.

  Dividends = $108(0.6) = $64.80 million.

  Retained earnings = NI - D = $108.00 - $64.80 = $43.20 million.

  Half of the capital budget will be debt, half will be common equity from retained earnings, so the capital

  budget will = $86.40 million.